Going nowhere fast

Not only has the government presided over the biggest financial bailout in Britain's history, it has

When America's sub-prime mortgage crisis hit these shores on 9 August - the day global credit markets froze over - no one could have quite imagined that nearly four months later the nation would still be grappling with its impact on our national life. New Labour, which built its reputation on economic competence, has seen it shattered by the fumbled handling of Northern Rock. And now it is reeling from a second successive crisis, the loss by HM Revenue and Customs of the personal details of 25 million people in the UK.

Not only has the government presided over the biggest financial bailout in Britain's history, it has sought throughout the affair to minimise its importance. It was only this month, when the Bank of England rapidly changed its growth forecast, projected up to three cuts in interest rates in the coming months and forecast potential recession and cascading share prices, that the gravity of recent events hit home.

The key question, which Alistair Darling has failed to answer, is: What is he going to do about the Rock? The sums involved are staggering. So far the Bank of England, as the lender of last resort, has advanced a staggering £24bn and rising. That is only part of it. In the turbulent hours following the run on the Rock's branches, the Chancellor finally listened to Mervyn King, governor of the Bank of England, and agreed to guarantee all the savings.

This guarantee was eventually narrowed so as to discourage speculative fortune hunters. But the bottom line is that the pledge is, in effect, a further government liability of between £10bn and £15bn, bringing the total notional cost of the rescue up to £40bn so far. That is a sum greater than the annual defence budget.

This is an unstable situation that the government cannot allow to persist, especially as the cost will have risen even further by February, which is Darling's deadline for sorting matters out.

The first sign of government impatience came this past week. At an unannounced session of the tripartite group, consisting of King, Darling and Sir Callum McCarthy, chairman of the Financial Services Authority, the board of the Rock was defenestrated. Out the window went the chief executive, Adam Applegarth, the person responsible for minting the Newcastle lender's disaster, and four non-executive directors. This group contained three people who should have known better: the former NatWest boss Sir Derek Wanless (the PM's health spending guru), Nichola Pease, scion of the Barclays family, and Rosemary Radcliffe, the former ombudsman for the FSA. Their reputations have been damaged irrevocably.

The choice now is between takeover or insolvency. There is no shortage of interest. When the first "soft" deadline for buyers was reached, several expressions of interest were received, including serious bids from the private equity banking specialists J C Flowers, Richard Branson's Virgin Money and a fund headed by Luqman Arnold, the man credited with turning around the fortunes of Abbey National.

None of these buyers would be capable of taking over Northern Rock without some guarantees that government funding would continue. J C Flowers is seen as one of the more credible bidders because of the banking expertise in its team. It includes the grand old man of finance, the former Lloyds TSB chief executive Sir Brian Pitman, who turned Lloyds around after disastrous lending to Latin America in the early 1980s. It is thought to have lined up commercial loans of at least £15bn, which would be a start. Like the others, J C Flowers would need assurance that government funding would continue until such time as the Rock's balance sheet can be normalised.

With almost all of these rescues, with the possible exceptions of the Branson and Arnold offers, the investments of private shareholders - of which there are up to 150,000 - would be wiped out. This is a great political danger for a government that wants to avoid a repeat of the Railtrack experience, when it was accused of abusing property rights.

Because of the perils of private rescue, including the possibility that the new owners might eventually walk off with a huge profit at the taxpayers' expense, the authorities are also looking at the possibility of placing the Rock in administration. This would create a legal quagmire as creditors fight over their share of the pie. But such a course would at least avoid "moral hazard" - the belief that banks are too important to go bankrupt.

Yet there would still be a serious concern. The sight of a bank being put into administration would deliver an enormous new shock to an already damaged financial system, reducing confidence even further. It might even tip other vulnerable mortgage lenders over the edge, leading to long-term damage to Britain's world-beating financial services industry.